Creating an effective valuation process for entrepreneurs and investors

1. The Price
Create an effective valuation process
for entrepreneurs and investors

2. Topics

3. The Capital Life Cycle
• Concept Stage: An idea and maybe a vision
• Seed Stage: Business formation, prototype
• Startup: Pre-production development, market
evaluation, alpha test
• Early Stage: Pre-revenue, beta and market testing,
rounding out management team, initial sales
• Breakeven: Refine market and marketing,
accelerate sales, follow-on product definition
• Growth: Further sales growth, identifying potential
acquisitions/acquirers/IPO

4. Capital Life Cycle

5. Valuation Requires a Holistic View
The Valuation process and results affect the immediate
and long-term prospects for the company, founders,
and investors
The Company: Sustainability
The Founders: % Ownership
The Investors: ROI
The Valuation process sets the tone of the relationship
between entrepreneur and investors for months and
years ahead

6. The Interests of Entrepreneurs and
Investors are Naturally Aligned
• They have a common goal:
• Building an enterprise that produces:
• Value for customers
• Profits for the company
• Opportunity for employees
• Financial returns for entrepreneurs and investors
• It is everyone’s mutual best interest to share
information as openly and completely as possible
• A relationship rooted in common understanding and
mutual trust creates the framework for creating a
great venture and sharing in the rewards

7. The Reality of Valuation
1. Investors look for the potential to scale revenue rapidly from
$30M to $100M to reach 5X-10X returns—a reasonable
desire for the risk they take
2. To grow a startup business usually requires multiple rounds
of investment
3. Therefore, the starting ownership percentage of the founder
and any pre-revenue stage investor will likely be diluted over
time
4. Dilution at exit can be expected to range from 25-70%, or
more, based on the number and size of investment rounds
and how the company performs
5. Understanding the mathematical effect of dilution helps an
entrepreneur see an investor’s point of view and be more
realistic about valuation
6. Investors have the money; entrepreneurs have the need

8. Constructing a Realistic Valuation:
Qualitative Advantages
• Founder is a serial entrepreneur
• Founding team and Advisory Board include
individuals known and respected in the industry
• Media recognition
• Milestones matched to capital requirements

9. Constructing a Realistic Valuation:
Quantitative Advantages
• A current cap table that is reasonable
• Intellectual property is protected and unique
• The market served is large and growing
• The future capital plan will provide funds for 18
to 24 months
• Early customers
• Paying customers

10. Vocabulary of Valuation
• Pre-Money Valuation: The value of a company
prior to investment
• Cash, patents, inventory, property, equipment, raw
materials, receivables, etc. net of liabilities
• New Investment: Capital raised during current
round
• Post-Money Valuation: Pre-Money Valuation +
new investment

11. Valuation Example: Series A Round
Assumption:
• Your company has a valuation of $1,000,000 and you
are the only shareholder
• You sell 33% of your company to investors to raise
$500,000 in a Series A round
Pre-Money Valuation: $1,000,000
New Investment: $500,000
Post-Money Valuation: $1,500,000
Resulting Valuation:
• You now own 66.67% of a company worth $1,500,000
• The new investors own 33.3%
• The Series A Post-Money Valuation becomes the new
Pre-Money Valuation

12. Valuation Example: Series A Round
Assumption:
• Your company has paying customers, valued IP,
and a valuation of $6,000,000
• Shareholders sell 33% of the company to raise
$2,000,000 in a Series B round
Pre-Money Valuation: $6,000,000
New Investment: $2,000,000
Post-Money Valuation: $8,000,000
Resulting Valuation:
• You now own 44.5% of a company worth
$8,000,000
• The Series A investors own 22.5%
• The new Series B investors own 33%

13. Dilution: A Dirty Word
• A reduction in value of common stock that occurs
because additional shares are issued or convertible
securities are converted into additional common
shares
• The larger the number of shares, the lower the
value of each share
• The value of pre-round stockholders shares will be
worth less unless the value of the company grows
• Investors negotiate with the knowledge that most
successful exits require multiple rounds of
investment—meaning that their ownership
percentage will be diluted over time

14. Down Round: Too-high Valuations
Cause Pain
• Down Rounds result when preceding valuation
was too high
• Previous investors’ share of the business is
diluted much more than normal
• The lesson:
Increasing valuation is very hard work
Most companies will require follow-on capital
Successful entrepreneurs set reasonable valuations

15. Sources of Capital
• You and Your Team: If you don’t invest in you, others will be
less willing to write checks
• Family, Friends, Fools: Unadvisable unless they are in the
business and can afford to lose every dime
• Angel Investors: They bring cash, industry experience,
amazing contacts, and the willingness to mentor and help
• Venture Capital: They favor growth stage opportunities. Less
than 2% invested in early stage
• Customers: If you have what they need, there’s the
possibility of a strategic partnership
• Government: Depends on solution and stage. SBIR/STTR
programs supply non-dilutive capital
• Banks: They look for positive cash flow first

16. Arriving at a Value
• The Reality in Early Stages: You are valuing a
company that has no revenue, no track record, and
few if any customers
• Asking investors to spend $500K-$1.5M based on
scenarios
• Valuation Considerations
Market Forces
Industry Experience
• Valuation Models
Exit Comparables—public and private
Net Present Value (NPV)—Discounted Cash Flows

17. Market Forces
• Most early stage investors seek deals in a
close-in geography
• What are investor colleagues paying?
• How much competition is there for local capital?
• How hot is the particular technology/market
segment?
• Are there local capital sources interested in
your sector?
• Do angels in your region syndicate?

18. Exit Comparables
• Consider public and private exits
• Draw data from national sources
• Subscription services such as VentureOne and Venture
Economics
• Dow Jones VentureSource
(dowjones.com/privatemarkets/venturesource.asp)
• SEC filings—www.sec.gov/cgi-bin/srch-edgar
• Find competitors’ or comparable companies’ S-1 filings and
deconstruct their financial history
• Talk to advisors, legal counsel, accounting
• Local angel groups have data on exits
• Angel Resource Institute (ARI) Halo Report
(http://www.angelresourceinstitute.org/data/ACEF/DataProje
ct/1H2012HaloReportFinal.pdf)

19. NPV of Discounted Cash Flows
• Requires several quarters of sales performance
• Application for companies in early to growth
stages

20. Deal Structure
• Deal simplicity and valuation are directly related
• If you want the money quickly, seek a simple
structure
• Higher valuation, complex deal structures, result in
more money going to lawyers
• Most private equity investments involve purchase of
stock with specific conditions and protections
• Those conditions and protections are manifest as
preferences
• Investors will get their money back first, with a
preferred return before anyone else

21. Investment Return Analysis
• Investors expect ROI based on their investment risk
• Each stage of company development requires a
certain type of investor

22. Founders’ and Management Team’s Payout
• Consider valuation in terms of absolute dollars
instead of as a percentage of company
ownership
• $3M payout invested at 4% in tax free bonds
generates $10,000 per month
• What does your company need to accomplish in
3 to 5 years to attract a buyer to make your
financial goals a reality?

23. Financial Structure
• As a rule, deal complexity is related to the
current status and history of accomplishment
• Private equity investment instruments have
evolved to protect the investor and offset risk
• Terms and conditions affect the structure of the
company and board, and management
responsibilities to the investors

24. Corporate Stock
• Common Stock: Generally voting, usually the first
stock issued. Basic rights provided by state and
federal law called “Blue Sky laws” govern offerings
• Preferred Stock: Ahead of common stock in
liquidation, with specific privileges regarding voting,
board representation, rights to documents,
dividends, repayment period, forced sale of the
company or offer of public securities. Can result in
a minority owner effectively controlling the company

25. Startup Advantages of Preferred
Stock
• Will attract more sophisticated, experienced
investors
• Provides for a dual-priced stock structure
• Common stock can have a substantially lower
price than preferred
• The lower-priced common stock can be used for
employee stock incentive plan
• Over time, the price differential between the
classes must converge

26. Convertible Debt
• Fully secured by assets, including IP
• Convert to securities, often at same terms of the
subsequent investment round discounted
• Above market interest rate with interest
payments often deferred
• May be used as a bridge between rounds
• Best convertible debt terms don’t avoid
valuation

27. Venture Debt
• Small, regional, non-bank venture leaders invest in
early stage revenue-producing firms
• Intention is a debt position
• Often include warrant provisions
• May be secured by intellectual property, other
company assets, and personal guarantee by the
entrepreneur, but are not always fully collateralized
• Not convertible to equity but can include warrant
coverage
• Rates are typically 2X bank rates or more

28. Term Sheets
• Start with standard documents
• Anticipate future rounds
• Develop a basic business understanding of
common terms
• Engage an experienced attorney

29. Common Terms
• Share Price
• Total Ownership
• Board Structure & Membership
• Liquidation Preference
• Dividend Preference
• Voting Rights
• Class Approval for Specific Events
• Anti-dilution protection
• Conversion of Stock
• Preemptive Rights (issuing treasury
shares in future)
• Right of First Refusal (buy pro rata
share if other S/H sell)
• Co-sale Rights (right to sell shares if
other S/H sell)
• Registration Rights (possibly in
subscription agreement)
• Demand Rights
• Piggyback rights (best efforts)
• No superior rights granted
• Follow-on and S-3 Registration Rights
• Expenses of Registration
• Indemnification of Selling Shareholders
• Assignment of Registration Rights
• Market Standoff/Lock-up provisions
(180 day)
• Notice (in time to convert)
• Information Rights (often precludes
information to others)
• Annual Audited Statements
• Monthly and quarterly P&L, Balance
Sheet, and Cash Flow
• Annual operating plan budget
• Other information reasonably
requested
• Reasonable right of inspection
• Key Personnel (who comprises key
personnel, insurance on same,
employment terms, etc)

30. Tips for Negotiation
• Maintain flexibility and mutual respect.
• Keep in mind:
How each party will make money from the deal.
There will surely be a next round of financing
The exit strategy
• Seed stage companies can expect a pre-money valuation of
$500K to $3M.
• When the deal closes, you will be in a relationship with your
investors for years to come. Start off on the right foot!